The Economic Model "Crisis" Has Changed

This year marks the tenth anniversary of the collapse of Lehman Brothers in September 15, 2008 and the ensuing global financial crisis. This summer, Lawrence J. Christiano et al. of Northwestern University in the US, wrote a paper titled, "On DSGE Models," to look back over the changes to the macroeconomic models before and after the crisis. DSGE is an acronym for dynamic stochastic general equilibrium (models), which are standard models in current macroeconomics.

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The DSGE model "Before the Storm," i.e. prior to the financial crisis, assumed a perfectly competitive market, and by also assuming "price stickiness" in this market, posited that the effects of monetary policies would materialize. These DSGE models were called New Keynesian DSGE Models, in the sense that they were modeled on Keynesian economics and were widely used among economists at universities to analyze monetary policies prior to the crisis.

These analyses have been criticized for failing to predict the global financial crisis. This failure was mainly due to the fact that DSGE models at the time pretty much ignored the financial system. However, Professor Christiano defends this position saying that, based on US economic data, financial systems did not appear to be significant prior to 2008, and that it is understandable that DSGE models ignored them. In other words, DSGE models do not apply to "crises that only happen once in a century."

Professor Joseph E. Stiglitz of Columbia University, in his 2018 paper, wrote, "what would one think of a medical doctor, who, when a patient comes with a serious disease, responded by saying, ‘I'm sorry, but I only deal with colds’?" Professor Christiano's defense does not seem to be a valid rebuttal to Professor Stiglitz's criticism.

The DSGE model "After the Storm," i.e. after the financial crisis, learning from its failure to predict the financial crisis, has systematically adopted such concepts as "banking systems" and "zero lower bound," and continues to develop. However, the mainstream way of thinking continues to work within the regular framework of "rational expectations" that rationally predicts the future using all information that is available, which many people find unsatisfactory. This point will be discussed later.

Professor Mark Gertler of New York University and Professor Nobuhiro Kiyotaki of Princeton University in their 2015 paper adopted banking systems in their DSGE models, indicated the possibility of bank runs and analyzed the vulnerability of financial systems. If the depositors withdraw their deposits at once, it would deplete the cash reserves and lead to a collapse. This is the definition of a bank run and the drastic financial crises such as the Lehman Brothers collapse can be made into a model as a type of bank run.

Following the crisis, each country continued its monetary easing and low interest rates have become the global norm. Researchers are currently focusing on "zero lower bound," whereby the nominal interest rate will not fall lower than zero. Given that the nominal interest rate of cash is zero, if the central banks tried to move toward negative interest rates, people would withdraw their deposits and retain cash in order to maintain, at least, a zero-interest rate. For this reason, central banks are faced with the zero lower bound, which forbids them to lower their nominal interest rates below zero.

When the economy is hit with the zero lower bound, hitherto unheard-of events occur. The zero lower bound together with distortions triggered by finances lead to extremely long periods of recession. This may be a factor in explaining the sluggish global economy following the financial crisis. Under zero lower bound, DSGE models predict that fiscal policies will have potent effects. The discussion surrounding whether to expand US fiscal policies and the research by academia have been integrally related after all.

Furthermore, under zero lower bound, DSGE models predict that forward guidance in the form of financial policy will become too effective (referred to as the "forward guidance puzzle"). Such puzzles will not occur for models that entail costs for communicating information.

Zero lower bound, as indicated above, has become the latest theme for DSGE research. This means that the Bank of Japan has been feeling its way around and pursuing its zero interest rate policy, which in theory has no correct answer, for almost two decades.

DSGE research after the crisis has incorporated non-linear variable factors such as distortion in finance and zero lower bound but still manages to overlook the causes of the crisis, such as "why did a shock of such magnitude that caused the crisis occur?" or "why did the vulnerability of the financial system accumulate?"

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In practice, the common notion is that the expanding asset bubble consisting of real estate and stocks acted as the fuel, and the crisis occurred as the bubble collapsed. However, no macro-economic model has been developed to illustrate such a common notion. As I explained in this column dated October 17, 2017, a theory for explaining the bubble exists but in this theory the bubble is referred to as a rational bubble, which does not aggravate the distortions in the economy and has little to do with the actual bubble.

There has been no model to explain the reality of a prolonged, long-term deflation despite the increase in money supply (This column dated June 17, 2013). Given that deflation is an appreciation in the value of money, long-term deflation may be interpreted as "a money bubble."

The difficulty in building models for bubbles under a framework of rational expectations stems from the "transversality condition." The transversality condition is the condition which dictates that "a rational person (unless he has an heir) will use up his assets by the time of his death." (See Figure) In other words, a rational person will not waste his assets by leaving them behind at his death. In an economy that satisfies the transversality condition, it follows that a bubble that expands so much that it bursts cannot exist.

Figure: How Can We Satisfy the "Transversality Condition?"

The transversality condition is an assumption of the individual's extreme rationality, which may also be characterized as super-rationality. It involves determining today's consumption and savings by taking into account that an individual's assets will not be wasted 30 years later. There is no such person in the real world. Consequently, incorporating "limited rationality," i.e. a looser assumption of an individual's rationality, in the model is also being tried. K-level thinking and robust control methods may be cited as examples.

Among these methods, Professor Christopher A. Sims of Princeton University upholds the theory of "rational inattention," which explains how people could hold different opinions while maintaining basic rationality without limiting human rationality from outside. Man's information-processing capacity is limited, while processing information also entails psychological costs. Consequently, when faced with huge amounts of information, we make a rational judgment to ignore certain parts of that information, and this is what is called "rational inattention."

Furthermore, we have different interests and even when faced with the same information, what we ignore will differ from person to person. Therefore, even when the same information is given to everyone, differences of opinion will remain because each person will rationally choose to ignore certain parts of that information.

Professor Sims points out that when there is a difference of opinion among people regarding expectations of inflation, investments increase due to monetary easing which leads to improvements in the economy. He also criticizes the basic premise of the New Keynesian Model which claims that the cause of inflation is overheating of total demand and emphasizes that it is rather the differences in opinions through rational inattention that should be considered as an important factor in inflation.

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By easing the transversality condition through theories such as rational inattention, phenomena such as the diffusion and collapse of the bubble and long-term deflation equilibrium may be explained. It has been a decade from the financial crisis but there are numerous themes to be pursued in macro-economic research.

Research Institute of Economy, Trade and Industry, IAA (JCN 6010005005426)JCN: Japan Corporate Number

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